Good News for Airbus and Boeing
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Defense companies get the bulk of their revenue from one customer: the U.S. government. Fortunately, that customer has deep pockets and a 245-year history of paying its bills. The government’s stability gives defense companies and investors some predictability when it comes to managing cash and projecting growth.
Companies in the defense sector offer a wide range of products and services to their main customer, and some are better investments than others. Here's what you need to know about investing in the defense sector and how to pick where to put your money.
|Lockheed Martin (NYSE:LMT)||Aviation and missiles|
|Boeing (NYSE:BA)||Aircraft and helicopters|
|Northrop Grumman (NYSE:NOC)||Nuclear efforts, bombers, space|
|General Dynamics (NYSE:GD)||Shipbuilding|
|Raytheon Technologies (NYSE:RTX)||Electronics and missiles|
|Leidos Holdings (NYSE:LDOS)||Government service, space|
There are about two dozen U.S.-based public defense and government services contractors, but we're going to break down these standouts.
If you are bullish on defense but would rather not choose among individual companies, you can buy shares in one or more exchange-traded funds (ETFs) that cover the sector. Three primary ETFs are focused on defense:
Defense stocks had performed weakly in 2020 as investors grew increasingly convinced that the White House would change hands, but so far those concerns appear to be overblown. The Biden administration’s first Pentagon budget is unchanged from the prior year, and, with a renewed focus on modernization and research, funding for defense contractors could trend higher in coming years.
Investors often associate defense with current events. But given the long lead times for programs and the strong consensus behind investment in the military, you can ignore the political noise and focus on finding the best-run defense businesses.
Many associate defense companies with tanks and guns, but the sector is defined more broadly to include companies that cater primarily to the Pentagon or other government agencies. The list includes weapons makers but also services companies that run IT networks, manage inventories, and perform other tasks for government agencies.
The strengths of defense companies include:
The Pentagon has awarded many important contracts in recent years, and the industry is well situated to see cash generation increase in the second half of the decade. That should translate into even higher dividends and could spur a wave of acquisitions.
The defense sector tends to be a stable group of companies with few failures but also few standouts. Here are some tips to consider when evaluating individual defense companies.
The Pentagon has an insatiable appetite for new equipment, but with aircraft carriers costing more than $10 billion apiece and F-35 fighters priced at $80 million or more per plane, there are limits to how much the government can buy. To figure out the likely winners and losers, pay attention to the budgeting process.
Early in the year, the Pentagon sends a funding request to Congress, which then, over the course of the spring and into summer, holds hearings to discuss priorities and make final allocation choices.
An investor need not hang on to every word, but the budget request, which is available on the Pentagon’s website, and commentary elsewhere can provide clues about which billion-dollar programs are an administration priority.
Presidential elections can create uncertainty for defense stocks, but Pentagon budgets tend to ebb and flow mainly based on current events and broader pushes to cut spending and balance the budget. Defense companies are typically only marginally affected by who is occupying the White House.
Companies will often highlight massive contract awards in press releases without explaining that those big award numbers are often spread out over many years and may be dependent on Congress approving the funds.
Pay attention to these metrics when evaluating defense stocks:
Defense companies know that investors are focused on these metrics and typically make the relevant information available on quarterly earnings reports or conference calls.
Defense companies manufacture lethal products and can be involved in supporting clandestine operations or intelligence gathering that some find unsettling. If you don’t want to support those activities, then investing in defense stocks is not a great choice for you.
Defense stocks, like many industrials, tend to be more plodding than high-flying technology or biotech stocks. Defense stocks are best suited for income-oriented investors seeking steady growth and rising dividends rather than immense valuation increases.
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